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11 Monetary and Fiscal Policy focus of the chapter ? This chapter uses the IS-LM model to look at the ways that fiscal and monetary policy can be used to stabilize the economy. We find that the effectiveness of monetary and fiscal policy depend on the slopes of the IS and LM curves. ? The combination of fiscal and monetary policy in an economy determines both the composition of output and the position of the AD curve. section summaries 1. Monetary Policy The central bank conducts monetary policy by engaging in open market operations(by buying and selling bonds. When the Fed sells bonds, it reduces the money supply. People send money to the central bank, which it takes out of circulation; in return, they receive a piece of paper they cannot spend. When the Fed buys bonds, it increases the money supply: people exchange those pieces of paper for money. An increase in the money supply does not initially affect people’s disposable income, or the autonomous component of AD; its initial effect is to lower the interest rate. Because this raises the level of investment without reducing consumption or government spending, aggregate demand then increases. Figure 11–1 uses an IS-LM diagram to show the short-run effect of a monetary expansion. Monetary policy is most effective when the LM curve is relatively steep, or when the demand for real money balances is not very sensitive to the interest rate (the parameter h in the money demand equation is small). It is also more effective when investment is highly sensitive to changes in the interest rate (the parameter b in the investment function is large), and when the marginal propensity to consume is small(i.e., when the IS curve is relatively flat. Figure 11(1 a monetary expansion lowers the interest rate, shifting the ad curve outward. There are two polar cases that have received a lot of attention: The first, called a liquidity trap, occurs when people are willing to hold as much money as is supplied (